This Selected Issues paper on Hungary presents an empirical analysis of the leading indicators for inflation and models the determinants of inflation. It summarizes current knowledge about the behavior of inflation and thus underpins the subsequent discussion of possible changes to the current nominal anchor framework. The paper analyzes the growth potential and fiscal issues affecting that potential, and the external constraint. The paper suggests that some relatively stable econometric relationships can be found, despite the considerable structural and policy changes that occurred during the 1990s.

Abstract

This Selected Issues paper on Hungary presents an empirical analysis of the leading indicators for inflation and models the determinants of inflation. It summarizes current knowledge about the behavior of inflation and thus underpins the subsequent discussion of possible changes to the current nominal anchor framework. The paper analyzes the growth potential and fiscal issues affecting that potential, and the external constraint. The paper suggests that some relatively stable econometric relationships can be found, despite the considerable structural and policy changes that occurred during the 1990s.

VIII. Sustainability in the Hungarian Balance of Payments87

A. Introduction

198. Hungary is well placed for a long period of strong growth to catch-up toward the per capita incomes of the EU countries. Investment opportunities will likely exceed domestic savings, attracting foreign capital and implying a deficit on the current account.88 However, financial markets can lose confidence in a country running high current account deficits. This chapter aims to estimate the current account position that is sustainable in the sense of limiting Hungary’s exposure to external crises or pressures in the medium–term, while allowing a sufficient contribution of external savings to growth. The international investment position of Hungary is described in Section B. Section C notes some aspects of Hungary’s economy that are relevant when considering the prudent external position. Sustainable current account and trade deficits under various scenarios for growth, foreign direct investment (FDI), and interest rates are estimated in Section D. Section E concludes.

B. Hungary’s International Investment Position89

199. In response to wide current account deficits in 1993–94, Table 18, the Hungarian government announced a medium-term economic strategy in Ministry of Finance (1995), which included the goal of reducing the current account deficit to a level not exceeding the inflows of FDI. It was projected that achieving this goal would lower net foreign debt-to-GDP a few percentage points by end 1997. In the event, Hungary’s net foreign debt actually fell from US$18.9 billion (45 percent of GDP) at end 1994 to US$11.2 billion (25 percent of GDP) at end 1997, Table 19. Valuation effects contributed only US$0.4 billion to this net debt reduction of US$7.8 billion.90

Table 18.

Hungary—Balance of Payments 1991–97 1/

(In millions of U.S. dollars; unless otherwise specified)

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Sources: Data provided by the Hungarian authorities; and staff estimates.

Through 1995 in convertible currencies, from 1996 in both convertible and nonconvertible currencies.

Excludes reinvested profits.

Through 1995 includes current and capital transfers, from 1996 includes current transfers only.

Through 1992 includes net errors and omissions.

Privatization receipts of US$969 million in 1997 are reclassified from portfolio investment to inward direct investment.

Net portfolio and other investment excl. equity securities plus net FDI in equity capital, less foreign reserve increases.

Includes intercompany loans.

Table 19.

Hungary—International Investment Position

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Sources: National Bank of Hungary, and staff estimates.

Foreign direct investment and holdings of equity securities, excluding intercompany loans.

Including intercompany loans.

200. This rapid debt reduction was made possible by high inflows of foreign equity investment, with the broader net foreign liability position remaining quite stable at just over 60 percent of GDP, Figure 25. Net equity liabilities rose by a total of US$9.2 billion from end 1994 to reach 36 percent of GDP at end 1997, primarily driven by US$8.1 billion of inward FDI over 1995 to 1997, including US$3.9 billion in privatization receipts from nonresidents. The remaining increase in equity liabilities reflects portfolio equity investment of US$1.6 billion over 1995–97, of which US$1.0 billion were privatization receipts. Thus privatization receipts of US$4.8 billion account for 62 percent of the reduction in net debt. Capital gains on foreign held portfolio equity—officially calculated using the BU X index—raised portfolio equity liabilities by US$1.0 billion in 1996–97, but exchange rate related revaluations reduced the stock of direct equity capital liabilities by a similar magnitude.91

Figure 25.
Figure 25.

Net External Liabilities: Debt and Equity

(In percent of GDP)

Citation: IMF Staff Country Reports 1999, 027; 10.5089/9781451817843.002.A008

201. By analogy with the financial theory of the firm, it might be argued that this shift in the composition of Hungary’s external financing from debt to equity was not relevant to the net value of its external position, so that sustainability was not improved.92 However, at the level of the firm the degree of leverage does affect the risk of illiquidity/insolvency. Similarly, the switch from debt to equity has enhanced sustainability in Hungary by reducing the risk of financial difficulties in response to shocks. The following factors are relevant:

  • While foreign debt is usually foreign exchange denominated, and a fixed payment in foreign currency is required regardless of the state of the economy, nonresident equity investors share in all the currency and other risks of the Hungarian company. Thus a negative shock is partly absorbed by a reduction in profits to foreign investors.

  • Debt service is linked to foreign interest rates, a source of risk that may be negatively correlated with economic performance, as higher EU interest rates will likely reduce EU demand for Hungarian exports. In contrast, income payments on equity liabilities are positively correlated with Hungarian economic performance.

  • While nonresidents can sell portfolio investments and refuse to rollover credit, transnational corporations cannot quickly liquidate direct investments, so pressures on the foreign exchange market from a loss in confidence will be lessened the greater the share of FDI in external financing.93 Nevertheless, the fixed capital associated with FDI could provide collateral for loans to speculate against the exchange rate peg.

  • Foreign holdings of equity involve a lower potential claim on foreign reserves in the event of a crisis, as equity prices will likely fall more than the price of bonds.

  • Equity investment supports the health of the domestic financial system, as corporate balance sheets are strengthened, making them safer borrowers.

  • FDI may ameliorate asymmetric information problems, as foreign portfolio investors learn from direct investors, and as the quality of information provision is likely enhanced, including for banks and companies without foreign investment.

202. Finally, the direct and external benefits of FDI inflows have improved Hungarian growth prospects. However, the reduction in the risk of limited access to international credit markets or of currency crises is not costless. Foreign direct investors have taken additional risk in the expectation of a higher returns, and the risk premia on equity investments will be substantially above those on credit. The higher income stream to foreign equity investors implies that Hungary must run a larger trade balance to achieve the same current account balance. Appendix I discusses the FDI experience and outlook of Hungary, as FDI will remain key to the sustainability of Hungary’s current account deficits.

Hungary’s foreign debt burden

203. Hungary was classified by the World Bank (1997) as a moderately-indebted middle-income (MIMI) country, based on data for 1993 to 1995.94 The EBRD (1997) also classifies Hungary as having medium levels of debt in 1996.95 Hungary’s exports of goods and services in 1997 were 128 percent higher than in 1994, helping cut gross debt-to-exports very sharply from a peak of 265 percent in 1994 to 97 percent by 1997, below the moderately-indebted range for both the World Bank and the EBRD, Table 20. Nevertheless, Hungary would still be classified as moderately-indebted as gross external debt-to-GDP is 53 percent at end 1997, though down from a peak of 70 percent at end 1995. What does this foreign debt burden imply for Hungary’s ability to manage external shocks?

Table 20.

Hungary—Debt and Debt Service Indicators

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Sources: National Bank of Hungary, and staff estimates.

Debt data includes intercompany loans from foreign direct investors.

Includes short-term other foreign liabilities by original maturity, money market instruments, and financial derivative liabilities. Does not cover any short-term intercompany loans.

Does not include publicly guaranteed non-government debt, which was US$0.9 billion at end 1996.

Total debt service excluding early repayments by the NBH and government.

Excludes payments on forint securities, that are overstated by the inclusion of secondary market transactions.

Principal repayments on medium-and long-term (MLT) debt, including early repayments.

204. Empirical research provides support to the conventional wisdom that higher external current account deficits and debt ratios increase the likelihood of an external crisis. Kaminsky et al (1997) survey 25 empirical studies on currency crises, together exploring a wide range of potential indicators for crises. They conclude that indicators of both domestic and external imbalances are useful, including international reserves, the real exchange rate, credit and money growth, export growth, inflation, and equity prices. The current account deficit and external debt profile did not receive much support as useful indicators of currency crises. However, Milesi–Ferretti and Razin (1998) found that for middle-income countries (with per-capita income above US$1,500 and population above one million) the risk of a currency crisis rises the wider the current account deficit, and the higher the level of foreign debt relative to GDP. The “event study methodology” analysis of currency crashes by Frankel and Rose (1996) confirms Milesi-Ferretti and Razin’s conclusion on the connection between deficits, debt, and external crises. This connection is illustrated with charts showing the difference between the behavior of a range of variables in tranquil times and at times of a currency crisis. These charts suggest that crises are typically preceded by higher than normal current account deficits, high and rising external debt–to–GDP, as well as by an overvalued real exchange rate, low reserves, smaller than normal FDI inflows, higher than normal foreign interest rates, and slow foreign growth. Similarly, a set of case studies by Milesi-Ferretti and Razin (1996) found that persistent deficits are more likely to result in an external crisis when the external debt or interest payments are high relative to exports, the real exchange rate is above historical averages, the financial system is weak, and the level of domestic savings is low.

205. While the above literature points at the risk implicit in high external debt ratios, its usefulness is limited by the fact that it does not control for factors that may affect the appropriate levels of external debt and deficits across countries and time. Low-income countries, where investment opportunities are likely to be higher than in developed countries, while domestic saving is likely to be lower, may optimally run higher external deficits and debt.96 Thus, in order to assess Hungary’s level of external debt, it is useful to compare Hungary’s foreign debt position with groups of broadly similar countries.97

206. Hungary’s debt–to–GDP is now broadly in line with the average of the MIMI country group, but with a more open economy, debt is lower relative to exports, Table 21. However, the MIMI countries are not an appropriate forward-looking benchmark for Hungary.98 A more relevant comparison is to middle-income countries with credit ratings that are “investment grade” (IGMI), see Table 22. The debt indicators for these countries provide information on financial market willingness to extend funds with less risk of interruption than speculative grade borrowers.

Table 21.

Sovereign Ratings, Long-term Foreign Currency Debt

At November 1998 1/

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The December 1998 upgrading of Hungary by Standard and Poor’s is incorporated.

Table 22.

Comparitive Debt and Debt Service Indicators

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Sources: National Bank of Hungary, and staff estimates.

WEO data from 1997 for: Chile, Colombia, Croatia, Czech Republic, El Salvador, Estonia, Hungary, Latvia, Malaysia, Mauritius, Oman, Panama, Poland, Saudi Arabia, Slovenia, South Africa, Tunisia, and Uruguay.

Ratios for the total of Czech Republic, Slovak Republic, Slovenia, Croatia, and Poland 1997 estimates.

Moderately-indebted middle-income countries, from Global Development Finance, 1998.

Debt service data for Hungary excludes amortization of forint debt and prepayments by government, as amortization data for forint debt is overstated by the inclusion of secondary market transactions. Prepayments are not excluded for the other countries, which may bias comparisons somewhat.

Slovenia is excluded from the sample for this average, which would be 696 percent including Slovenia.

207. Hungary’s 1997 debt position relative to the estimated positions of the 17 other IGMI countries is illustrated in Figure 26, for both gross debt and gross debt net of official reserves.99 The polynomial trend lines show the expected pattern of falling debt ratios as per capita GDP rises, though this effect starts beyond per capita income levels of US$7,000 to US$8,000 on a PPP basis. It seems likely that countries with a lower per capita income attained an investment grade rating largely due to their low debt levels. Hungary has among the highest debt ratios to GDP of the IGMI group, exceeded only by Tunisia and Panama, with net foreign debt about 10 percentage points of GDP above trend for its income level. More IGMI countries have higher debt ratios to exports, particularly the less open Latin American economies. However, Chile is a primary goods exporter, and Columbia, Uruguay, and Tunisia are diversified exporters, so they likely require lower imported inputs per unit of exports, making the debt-to-exports comparison less informative.

Figure 26.
Figure 26.

Investment Grade Middle-Income Countries: External Debt Ratios, 1997 Estimates

Citation: IMF Staff Country Reports 1999, 027; 10.5089/9781451817843.002.A008

Source: World Economic Outlook database

208. The manufactures exporters of Central and Eastern Europe (CEE) are the most relevant benchmark in terms of exposure to shocks, Table 23, and the greater similarity of trade composition also makes comparisons of debt-to-exports ratios more reliable. Hungary’s net foreign debt is substantially higher than the average of 9 percent of GDP in the other CEE countries, and though gross debt-to-exports is broadly in line with the 89 percent CEE average, net foreign debt-to-exports is twice the level in this group.

Table 23.

Foreign Debt Indicators of Central and Eastern Europe, 1997 1/

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Estimates from desk economists, subject to revision when final data is available.

Total of the Czech Republic, Slovak Republic, Slovenia, Croatia and Poland, and ratios for this group.

Ratio to GDP of the average of exports GNFS and imports GNFS.

Credit Ratings are as of November 1998.

209. In summary, although Hungary’s debt burden is much reduced from the high levels reached in 1994, its debt relative to GDP remains higher than in the group of investment-grade middle-income countries. Relative to exports, Hungary’s net foreign debt is also above that of the manufactures exporters of CEE. Hungary also appears to be approaching the income level where investment-grade countries typically start to reduce net foreign debt.

Other external indicators

210. External financial crises may reflect an underlying concern about solvency, but vulnerability to crisis also reflects the liquidity and foreign exchange exposures of an economy. The following suggests that Hungary appears adequately liquid, but is reasonably reliant on continued access to international financial markets due to relatively high debt service ratios and significant nonresident investments in domestic securities.

211. In spite of the fall in Hungary’s debt stock indicators, total debt service has risen to 25 percent of GDP in 1997, from 11–13 percent over 1990–94, Table 20. This rise reflects higher amortization payments, as gross interest payments have remained relatively stable at 4 percent to 5 percent of GDP. However, amortization data is distorted by debt prepayments, and also by the inclusion of payments related to secondary market transactions in domestic government securities. Excluding these items—though not prepayments by the private sector—the debt service ratio is about 17 percent of GDP over 1996–1997, still high compared to the benchmarks in Table 22. At end 1997 Hungary’s short-term debt was 16.3 percent of the total, similar to the benchmarks in Table 22.

212. Some commonly used external liquidity indicators are provided in Table 24. While foreign reserves strengthened in the first half of 1998, there was some reduction in liquidity by November 1998, following the impact of the Russian crisis. However, foreign reserves remained strong at 4.1 months of imports of goods and nonfactor services (GNFS), and more than twice the level of short-term foreign liabilities. It is notable that credit institutions account for most short-term liabilities, but a majority of these are covered by their own short-term foreign assets. Foreign debt falling due in the next year is estimated at US$6.7 billion in November 1998, and was more that fully covered by foreign reserves. Foreign holdings of Hungarian domestic bonds increased sharply in the first half of 1998, but there were significant outflows (US$0.5 billion) by November 1998. Nonresident investors also hold substantial portfolio equities, together with bonds accounting for about one-third of reserves in November 1998, so Hungary is significantly exposed to portfolio outflows. To the extent permitted by capital controls, capital outflows could reflect the transactions of residents as well as nonresidents, so in principle the adequacy of international liquidity should be assessed relative to a broad measure of financial sector liabilities. Foreign reserves covered 44 percent of M3 at November 1998, which appears relatively high, but there are as yet no norms for this ratio akin those for the reserves-to-imports ratio.

Table 24.

Hungary: Indicators of External Liquidity, 1996–98

(In billions of U.S. dollars at end of period, unless otherwise indicated)

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Source: Statistics Department, National Bank of Hungary.

Includes short-term loans (by original maturity), money market instruments, and financial derivatives (the market value of positions implying a net payment). Does not include any intercompany loans.

Portfolio equity liabilities from IIP data, where each foreign holding is less than 10 percent of paid in capital.

The amount of debt with put options that can be called within the next year is not included.

Assumes that the share of private MLT debt maturing equals that of publicly guaranteed MLT debt, likely an underestimate.

213. Borrowing conditions on international financial markets are fairly good for Hungary. In early 1998, Hungarian eurobond issues were accepted on similar terms to the less advanced members of the EU, at a time when many other emerging market countries had delayed bond issues. By late 1998, Hungary still had good access to international credit markets, but spreads had widened following events in Russia.100 In contrast, credit ratings agencies place Hungary towards the bottom of investment grade countries, Table 21. Analysis based on research by Cantor and Packer (1996) is suggestive that the agencies may be under-rating Hungary relative to its fundamentals. Their estimated equation for the average of Moody’s and Standard and Poor’s ratings (on a scale where 1-Be/B- and 16=Aaa/AAA) with statistically insignificant variables omitted is:

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This equation predicts that Hungary would have a Baa1/BBB+ rating, two grades above the actual ratings in early 1998.101 Nevertheless, both Moody’s and Standard and Poor’s upgraded Hungary in 1998, and Standard and Poor’s maintains a positive rating outlook, suggesting that any potential under-rating may not long remain.

C. Economic and Financial Structure of Hungary

214. This section briefly notes some features of Hungary’s economic and financial structure that bear on how exposed Hungary is to balance of payments pressures, focusing on Hungarian savings behavior, the composition of trade, and financial sector health.

215. A key factor underpinning the swings in the current account balance seen in the 1990s was the volatility of nongovernment savings, which collapsed from 23.8 percent of GDP in 1990 to 11.6 percent of GDP in 1993, before recovering to 21.1 percent of GDP in 1995.102 While these developments partly reflect transition-related factors affecting enterprise profitability, volatility in household saving was also significant, with the household saving rate falling from over 16 percent in 1992 to 9.5 percent in 1993.103 The current account deficit can quickly rise to unsustainable levels with such savings shocks, so some caution is warranted until a record of greater stability in savings is established.

216. Hungary was classified as a diversified exporter in World Bank (1997) based on 1993–95 data. However, recent export growth has focused on manufactures, which accounted for 63 percent of goods and services exports in 1997, Table 25. Of manufactures exports, 77 percent went to the EU in 1997, thus the key risk to exports is the EU durable goods cycle. The volatility of manufactures imports by the EU has been high recently, as imports of key EU members104 from all other countries fell 7 percent in 1993, but rose 11 percent and 19 percent in 1994 and 1995, respectively.

Table 25.

Structure of Hungarian Trade, 1997

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Source: National Bank of Hungary, Monthly Report Table III/V, preliminary data.

217. The Asian crisis has re-emphasized the importance of a sound financial system for international financial market confidence. Hungary has privatized most of the banking system to strategic investors, with foreigners owning 61 percent of banking sector capital at end 1997.105 The relatively good health of the banking sector, and the progressive development of other financial markets, see Van Elkan (1998), suggests that with the vigilance of authorities, Hungary’s financial system should be able to effectively allocate debt-creating capital inflows of a reasonable magnitude.

D. Current Account Deficits in the Medium-Term

Two paths for net foreign debt

218. This section seeks to analyze the volume of capital inflows and thus the current account deficit that would be sustainable. The analysis in Sections B and C suggests that an increase in Hungary’s debt ratios could prevent significant further improvements in Hungary’s credit worthiness, thus current account deficits that would increase Hungary’s debt ratios can be considered inappropriate. Should the authorities aim at a further reduction in external debt ratios? Hungary’s openness, high inflows of FDI, and the falling share of public foreign debt tends to reduce its exposure to external crisis.106 However, the volatile savings record and the less diversified export structure urge greater caution with respect to the external position. The relatively high level of Hungary’s net foreign debt-to-GDP compared to the IGMI countries, also suggests that a further debt reduction over time would be helpful.107 A modest reduction could be realized by targeting no increase in net foreign debt in foreign currency terms, allowing growth and real exchange rate appreciation to erode the debt ratios. The following compares the implications or this strategy against that of stabilizing net foreign debt relative to GDP.

219. The current account deficit (CAD) that would stabilize net foreign debt-to-GDP (NFD), is given by the sum of equity capital inflows (ECI) and the level of debt-creating capital inflows (DCI) that is debt-stabilizing (variables in percent of GDP);

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The debt–stabilizing level of DCI is a proportion of the outstanding debt that is increasing with the medium-term growth rate (g). Note that the growth rate is defined in terms of the currency composition of net foreign debt, and is the sum of real GDP growth, foreign GDP deflator inflation, and the real exchange rate appreciation of Hungary on a GDP deflator basis. Assuming a medium-term real GDP growth outlook of 4 percent to 5 percent, foreign inflation of 1 percent to 2 percent, and real appreciation of the forint on a GDP deflator basis between 0.5 percent and 1.5 percent, a feasible medium-term range for g is 5.5 percent to 8.5 percent.108

220. With GDP growth 6 to 8 percent in foreign currency terms, the end 1997 level of net foreign debt of 24.7 percent of GDP could be maintained with net DCI of 1.4 percent to 1.8 percent of GDP, or about US$0.7 to US$0.85 billion in 1998, Table 26. Further external debt reduction by government and outflows of foreign investment by Hungarian residents would be consistent with larger gross DCI to the private sector. Under the strategy of targeting zero net DCI, net foreign debt–to–GDP would be cut by between 6 and 8 percentage points of GDP by 2002 with growth between 6 percent and 8 percent, Table 27, similar to the reduction estimated by Krueger (1996). Under the conservative expectation that exports grow with GDP, net external debt-to-exports would be cut by 11 percentage to 15 percentage points, implying foreign debt net of reserves broadly consistent with the average 50 percent ratio to exports in the IGMI countries.

Table 26.

Debt Stabilizing Debt-creating Capital Inflows

(In percent of GDP)

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Table 27.

Net foreign debt, projections for 2002

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Measured in terms of the foreign currency composition of net foreign debt.

Net debt to GDP stable at 24.7 percent.

Assumes net debt creating inflows are zero, so net debt is fixed in foreign currency terms.

221. Net equity inflows must also be estimated to calculate the current account deficit implied by each strategy. Given the already high participation of foreign investors in the equity market, further portfolio inflows will be constrained by new equity issues, and portfolio equity outflows may rise, suggesting that net portfolio equity inflows may be small. The potential FDI inflow is discussed in Appendix I, finding that 3 percent of GDP on a cash basis would be a reasonable expectation in the next few years (1998–2000), allowing for some outward direct investment. This FDI inflow implies debt-stabilizing current account deficits on a cash basis of 4.4 percent to 4.8 percent of GDP for growth rates in foreign currency terms of 6 percent to 8 percent, respectively, and 3 percent of GDP to freeze net foreign debt in foreign currency terms.109

Trade balance and foreign interest rates

222. This section reports estimates for the path of the trade balance in goods and nonfactor services (GNFS) that would be consistent with a sustainable current account position, by deriving the GNFS balance as the residual between the current account deficit and the estimated path for international investment income and current transfers. The current account deficit remains constant on an accrual rather than cash basis, reflecting a stable gap between investment and savings, and a stable total FDI inflow. The simulations are not projections, they merely illustrate the implications of running certain deficits on average, under the following assumptions:

  • Current BOP transfers: these are significant a source of Hungary’s disposable income at 2.2 percent of GDP in 1997. Transfers are assumed to grow at the 2.6 percent rate observed in the 1990s, so this inflow declines as a share of Hungarian GDP over time, which is to be expected as Hungarian per capita income converges.

  • Reserves and other nonequity foreign assets: these are assumed to be stable at 27.9 percent of GDP, which likely underestimates the potential expansion in foreign assets as pension and investment funds diversify from Hungarian securities.

  • Net equity liabilities: the official data is adjusted upwards by US$1.8 billion, reflecting cumulative retained earnings of foreign owners not recorded in the BOP estimates of FDI, as discussed in Appendix 1. Depreciation of the capital owned by nonresidents at an annual rate of 5 percent is assumed in estimating equity income.

  • Exports of GNFS: are assumed to grow 2 percent faster than GDP in the medium-term, which seems conservative relative to recent growth rates.

  • Interest payments: official BOP data include the marking-to-market of debt swaps in both interest payments and receipts, as reflected in the high implied interest rates on foreign assets and debt in 1997, at 9.8 percent and 8.2 percent respectively. The gross interest data for 1997 was adjusted down by US$0.5 billion, producing implied interest rates with a spread of 1.0 percent. This spread is assumed to be stable over time; though the spread paid on sovereign loans may decline, the share of nongovernment loans with higher spreads may rise.

  • Equity returns to foreign investors: are estimated at 8.4 percent in 1997, including retained earnings. The rate of return is assumed to rise linearly to 3 percent above the cost of foreign debt by 2002, as the full benefits of earlier investments are realized.

  • Repatriated equity incomes: were 43 percent of the total estimated level of equity income to foreign owners of US$1.0 billion in 1997. It is assumed that this repatriation rate is unchanged, so that as total equity earnings increase a larger part of total FDI is funded by retained earnings.

  • Total FDI including retained earnings: is assumed constant at 5 percent of GDP, consistent with FDI on a cash basis at just over 3 percent of GDP over 1998–2000, but cash FDI declines to 2.8 percent of GDP by 2007.

223. The simulation in Table 28 is for stabilizing net foreign debt-to-GDP, while Table 29 is for freezing debt in foreign currency terms. Each assumes 6 percent growth (in foreign currency terms) and 5 percent foreign interest rates. As expected, net interest costs are stable in Table 28, but total investment income deteriorates as earnings on foreign owned equity rise.110 By 2007 an improvement of 1.2 percent of GDP is needed in the GNFS balance from 1998, reflecting a 0.4 percent of GDP reduction in cash FDI, a 0.5 percent of GDP reduction in current transfers, and a 0.3 percent of GDP increase in repatriated equity incomes to nonresidents.111 Table 29 shows similar trends, but as net interest costs decline by 0.6 percent of GDP, the required improvement in the GNFS balance is reduced to 0.6 percent of GDP.

Table 28.

Medium-Term Balance of Payments Simulation: Stable Net Foreign Debt to GDP

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The end 1997 inward FDI stock is adjusted for estimated cumulative retained earnings of US$1.8 billion, and interest payments are adjusted by US$0.5 billion for the effect of “marking-to-market” on debt swaps.

Includes estimated retained earnings on FDI in investment income debits.

Includes net employee compensation, a relatively small item.

Note that changes in international reserves are incorporated into debt-creating inflows.

In terms of the basket of foreign currencies comprising net foreign debt, largely DM and USD.